Business Associations Class Notes 6/15/04


Two or three loose ends from yesterday:


Would our client from yesterday have any indemnification rights or rights over the independent CPA firm, the investment banking firm or the good Ohio law firm that represents the company?  A bare possibility exists against the accounting firm depending on what the GAAS standards were for alleged debtors with post office express boxes.  As to the law firm, Shipman doubts it very much.


The law firm’s role in offerings


Law firms seldom say that they’re undertaking a 100% investigation or an audit.  There are exceptions to that: if there is a sexual harassment claim in a corporation and four of the seven directors authorized the investigation of the fifth director, then the law firm will be extremely careful and investigate the facts fully.  Generally speaking, however, they expressly state in their opinion that they are relying on facts supplied by officers and in the normal course of events, if there is nothing strange about what the officers tell them, they can do so.  Both CPA firms and law firms will sometimes require officers’ certificates.  They will have the officer read, sign and date it.  If you’re an officer, be careful!


In Sarbanes-Oxley § 404, as to public companies, there has to be a system of firm internal controls established.  This has led to an elaborate system of subaffirmations that top management requires from division managers, addressed to them.  This creates additional expense, to the tune of $4 million a year for a $1 billion company.


For lawyers, in giving opinions they will negotiate in the initial agreement that in certain matters they may reasonably rely upon officers’ certificates.  That’s a good way to cut down on legal cost.  In a public offering, the outside law firm’s duties run in two different directions: (1) to the officer and directors, and (2) to the quasi-client.  If the lawyer knows or reasonably should know that what is being done violates the law, then the quasi-client (buyer of the security) can sue the lawyer.


In Tomash, which had to do with indemnification, the director there had asked the lawyer for the company whether what he was doing was legal, and the lawyer said: “Go ahead, it’s legal.”  The lawyer was wrong, and an SEC injunction was issued against him.  His best cause of action was against the corporate lawyer who gave the advice, and then under respondeat superior against the corporation.


What about the legal opinion to the underwriters?  It’s a long opinion on many matters.  The outside law firm would be liable to the underwriter.  One opinion, for example, is that the corporation has picked the correct SEC form to file on.  In the case of a mistake, there is clear liability.  Lawyers never opine that there has been full compliance with the federal securities laws because these laws include anti-fraud provisions and there’s no way that the lawyer can be clear that he’s getting the full story from all the officers.  However, the underwriters do require an independent opinion concerning the truthfulness of the prospectus.  “Based on what we know (without a full audit or full investigation), nothing has come to our attention that causes us not to believe that the prospectus is truthful in all material respects.”  The next sentence will say: “The preceding sentence does not relate to the financial statements.”  In the real world, there is a lot of overlap between the narrative and financial statement portions of the prospectus, and one of the big issues is whether there was an overlap in the case we talked about.


What about the law firm’s liability to the client?  Their opinion is limited and there is probably no possibly of liability.  But lawyers can be held liable.  One of the big law firms in Dallas, out of tax shelter advice, settled in the amount of their malpractice policy, $75 million, based on their recommendation of bogus tax shelters.


Comfort letters


One more thing about deals, registered and unregistered: as to the unaudited interim statements (CPAs only audit annual statements), you can get a “comfort letter” from the CPA firm.  The purchaser will require such a “comfort letter” concerning the unaudited statements.  It reads much like the attorney’s negative opinion: “We have not conducted an audit or a complete investigation.  This is supplied to you alone; nobody else may rely on it.  The opinion may not be assigned or transferred and it applies only to this deal.”  Lawyers in practice refer to this as dealing with the “sister-in-law problem”.  Say you’re asked for a big opinion for a client.  Suppose the guy gets the opinion and the sister-in-law has a similar problem, and the guy copies the letter for her, but it doesn’t fit her situation.  If you don’t have that clause, it’s possible that the sister-in-law can sue you.


They will also state: “We have conducted certain limited inquiries concerning the unaudited statement.  To the best of our knowledge, in our opinion [to prevent a warranty or contract], based on what we know, the interim statements contain no material untrue matter and they are consistent with the bases on which the audited statements were prepared.”


Comfort letters are useful for three reasons: (1) The letters come with a prestigious letterhead.  (2) The accountants take this seriously, even though they don’t audit.  (3) You probably trigger R.2d Torts § 552 because the auditing firm is on notice of special foreseeability.


There are instances in which it would be wise to get audited statements for the six month period if you’re really suspicious.  But it will take a while a cost a lot of money.  It costs almost as much to certify a six month period as it does to certify a twelve month period.


Under New York law, § 552 is not followed.  New York law is unique: this process hooks you up to a negligence standard against a CPA firm, whereas if you don’t do it, you’ll have to prove gross negligence in order to sue that firm.  The comfort letter establishes privity, or, as the Court of Appeals of New York says: “virtual privity”.


Connecting the ’33 and ’34 Acts


In general, the Securities Act of 1933 deals with offerings by issuers and affiliates of issuers that are public nature.  If an offering is private, 4(1), 4(2) and Rule 506 will usually exempt them.  The Securities Exchange Act of 1934 deals primarily with the day-to-day trading markets, both the stock exchanges (NYSE, AMEX) and the over-the-counter markets (NASDAQ).


If you’re a big public company, there is nothing that will exempt you from registration, but you’ll get shorter forms under the Securities Act of 1933.  Be aware of these two forms: under the ’33 Act, you use S-1 if you can’t find a simpler form.  We have talked about the S-8, which is a simpler form for employee stock options and employee stock purchase plans.  The S-8 can only be used by public reporting companies.


In the Securities Exchange Act of 1934, at § 12 we find talk of registration of securities, too.  The big form you use, either with a stock exchange or with NASD is Form 10 under the ’34 Act.  In addition, you will have to file a listing application and signed listing agreement with the stock exchange or NASD.  If you’re a new company, going public, you usually will list on an exchange or on NASDAQ at the same time that you have your ’33 Act statement approved.  But you don’t have to say the same thing three different times.  Once your S-1 is effective, you just fill out the first couple of pages of the Form 10 and listing application and then attach your ’33 Act statement to it.  Then you incorporate by reference.  This information is publicly available in Washington.  You can go and look at the paper or you can look it up on EDGAR.


At § 10(b) of the Securities Exchange Act of 1934, fraud is prohibited in connection with the purchase or sale of any security by any person.  It covers everything!  It’s not often useful to plaintiffs due to the restrictions of the ’95 Act and the fact that you always have to plead scienter with great particularity.  However, the last two U.S. Supreme Court cases on the subject have turned out to be very pro-plaintiff.  American investors bought warrants in a Hong Kong company that also did business in California.  They went to exercise the warrants, but they were refused.  They sued the Hong Kong company in federal court in California.  They proved to the district judge that the Hong Kong company had intended to squelch their efforts at exercising from the beginning.  The case went to the Supreme Court: was this a proper use of 10b-5?  The Rule requires that only a purchaser or seller of securities can sue.  But the options were clearly securities.  The Supreme Court held that if they had the actual specific intent to screw them over from the beginning, then that’s fraud!


§ 14(e) of the Securities Exchange Act of 1934 relates to any tender offer by any person for any security.  If you make a tender offer to a little company and you use the mails or means of interstate commerce, you’re covered.  But § 14(e) does not specifically require the use of the mails or interstate commerce.  If you’re using it affirmatively, it’s usually present, so plead it and prove it.  The Supreme Court has held that where the statute doesn’t require an interstate commerce connection but the plaintiff proves it, you’re okay.


Compare §§ 12(a)-(b) and 12(g).  §§ 12(a)-(b) are voluntary because no one is required to list their securities on a stock exchange.  § 12 (g) is mainly mandatory in that if you have over 500 shareholders and over a certain amount of money in assets, you must file.  § 12 (g) also permits voluntary filing.  Why would anyone want to do that, though?  The answer comes from the Williams Act.  The big deal is §§ 13(a)-(b): public periodic reporting with the SEC is required.  Once you go public and list on the NYSE, you’ll be filing reports thereafter.  Under §§ 14(a)-(c), you have proxies.  Under § 16, you have insider trading reports.  § 16(b) has to do with recapture of short-swing profits.  § 16(c) deals with an officer, director, or 10% shareholder and says that a short sale is a crime.  A short sale is a sale of stock you don’t own.  You sell short when you think the stock is going down.  In the 1920’s, the CEO of a company sold his stock short and made a mint!  This was deemed “un-American”!  Also, you can’t sell “against the box”, meaning borrowing it from your own stock certificates in your safe deposit box.  You have to actually transfer the certificate when you sell the stock!


The Williams Act, §§ 13(d)-(e) and 14(d)-(e), deals with control share acquisitions and tender offers.  §§ 14(d) and 13(d) are restricted to § 12 companies.  But there’s an oddity: § 14(e) and the regulations thereunder apply to tender offers for any security, whether registered or not.  For a private company, go to the regulations for § 14(e) and Rule 10b-13.  For a public company, go to § 14(d) and regulations plus § 14(e) and regulations plus Rule 10b-13.  Most regulation of tender offers today is under state law but the federal law is important, too.


There are two other ways you can become subject to § 13.  If you’re a public utility holding company or an investment company, those statutes incorporate the Securities Exchange Act of 1934 provisions.  Under § 15(d) and regulations of the Securities Exchange Act of 1934, if you file an effective Securities Act of 1933 statement, you become subject to § 13.  Now go to 15c-(2)(11), which says that the SEC has power by regulations to govern quotations for securities on a stock exchange or the over-the-counter market.  Rule 15c-(2)(11) is mind-boggling, but it has a simple purpose: before this Rule, if you were a securities broker-dealer and you wanted to enter into the NASD quotation system, you could do it for quotations for a company not subject to § 13 of the Securities Exchange Act of 1934.  The Rule reverses this: no broker-dealer will enter quotations for a company not subject to § 13 of the Securities Exchange Act of 1934 into a quotation system.  There is one exception, which is if a broker-dealer, on his own, gathers material substantially similar to what would be in the SEC file for a § 13 company, in which case the broker-dealer can enter quotations.  This would be easy for an insurance company because, for 100 years, state law has required insurance companies to maintain mountains of public periodic information at the state capitol.  It’s difficult aside from insurance companies to do this.



Hypothetical on § 12(g)


There is no conflict of interest.  We never represented the person before today.  She should clear it with her boss.  She’s the COO, and she must work for a CEO and the board of directors.  Recall the Bernie Ebbers problem.  Bernie found out that a guy was selling stock without his permission.  He took him out to eat, and when they got back, his office had been cleared out.  Consider Rule 10b-5 and R.C. 1707.44: if you sell securities of an insolvent person and the other side doesn’t know of the insolvency, that’s a crime under Ohio law.  But the company is solvent in this case.  Also, consider the effect of Rule 10b-5 on insider trading.  If there is undisclosed, unfavorable information about the company, the COO can’t trade.  It would be a crime, with the possible exception of a new Rule, but the effect of the Rule isn’t clear.  Shipman thinks that there is no problem under these facts.


Would a § 13(d) report have to be filed?  She owns far less than 5% of the shares outstanding.  Why do we raise this issue?  The rules under § 13(d) deal with beneficial ownership.  Probably no problem there.  A § 16(a) report would be due under Sarbanes-Oxley.  It must be done electronically within two or three days.  This won’t be a problem because most bigger companies have people either in the corporate secretary’s office or general counsel’s office who are equipped to make these filings for her, and with advance consultation with those people she could get them to file the report on her behalf.  If she happened to be out of town on the day that it’s due, she could give those people a signed, written power of attorney to file the reports.  If you’re over 5%, there will be both a § 13(d) report and a separate § 16(a) report.  What’s the theory behind the two sections?  Under § 16(a), the market pays tremendous attention to what the insiders are doing.  Under § 13(d), it’s an early warning system of a possible takeover bid.  If you’re over 5%, whether or not you’re an officer, director, or 10% holder, you’ll have to report.  We don’t think there’s a problem under § 16(a).  Corporate insiders hate this, but the system works pretty well according to Shipman.


§ 16(b) says that if the client or people within her beneficial ownership range purchase and sell within a six-month period or sell and purchase within a six month period, then any shareholder can bring a suit and recapture the difference.  Even if she is pure as the driven snow, it’s no defense.  What’s “sale and purchase”?  Let’s say that looking back six months over her beneficial ownership range (that is, your family, trusts and other close people).  We look backwards first and see if she or anyone in her beneficial ownership range has made a purchase in the past six months.  If it was more than six months, we look forward.  It makes sense that if she buys stock for $10 and sells for $70, it’s clear she’ll be hit with $60 per share recapture.  But if she sells for $70 and then purchases for $40, $30 per share will be recaptured.  We have to warn her about the future!


Next up, we go over Rule 144, which never applies to a company that is never public.  This Rule is very favorable to public companies and their insiders and those buying in exempt transactions from insiders.  Our client is under Rule 144 even if all the stock she bought was option stock or stock she bought through a broker on the securities market because she is an affiliate as defined in Rule 405.  We make a checklist for the company: are they current in their § 13 filing?  If not, we can’t use the Rule.  Next, we compute her beneficial ownership (including ownership by her husband and kids and live-in mother/mother-in-law, family trust, partnership and charitable organizations that she runs).  We look at those people’s transactions and see if this proposed transaction, coupled with others, will pass the volume limit test.  We explain that it must be a brokers’ transaction.  Next, if she has acquired any security in an exempt transaction from the issuer, there will be a holding period of one year that will attach.  In addition, any securities of that nature that she has will have a legend on them, and she’ll have to go to the transfer agent and get securities without a legend because legended delivery is per se bad delivery.  It must be squeaky clean!


She will have to timely file a Form 144.  If she was over 5%, she would have to do three different filings!  In practice, half of the transactions have to be unwound, but people screw it up.  You’ll be dealing with a local office of the brokerage house.  When the Form 144 hits after the transaction, the New York compliance director will say the form is not right and you have to cancel it and do it over.  How do we avoid this?  You can file the form a week or so before the transaction, get the local brokerage house guy and the New York compliance director to both sign off by fax before you actually sell.  In the real world, studies have shown that only half of the letters of credit transactions go through.  That’s part of why American Express makes money off of travelers’ checks.


The company may have filed a stop transfer order with the transfer agent because she’s a #2 officer.  How do we deal with this in advance?  The transfer agent will usually accept the written opinion of internal counsel that it’s okay.  Get that file in advance with the transfer agent.  That will eliminate the stop transfer order.  The internal counsel will usually request the opinion of the personal lawyer for the officer or director and we can give it.  Lastly, the brokerage house that she has got her to fill out a questionnaire, with one question being: “Are you the officer or director of a public company?”  Many brokerage houses also require the opinion of the internal counsel for the company and again, on that opinion, the internal counsel will usually require our opinion as a condition precedent.  It is a bit complicated, and there is a lot of paperwork.


She should pick a specific certificate with a high tax basis.  She should use specific identification.  For § 16(b) purposes, you cannot specifically identify.  A court will pick the stock with the lowest basis.  Probably all of her stock has a basis lower than $70 per share.  A lot of it is probably option stock for which she may have paid $20 or $30 per share.  You will have to go over the tax effects with a tax attorney.


Make sure to get reasonable diversification of investments!  If all our client’s wealth is in her house and this stock, she would be well advised to sell some of the stock and diversify her portfolio a bit.  At Enron, there were mid-level executives in just this situation, holding millions of dollars in Enron stock on January 1 of the year.  By the end of the year, the stock was worth $0.10 per share rather than $70 or $80.  The company looks very good and she seems to have been there a long time.  On the other hand, if all she has is the house and this, she has lumped all her eggs in one basket.  But on the other, other hand, if you take out a second mortgage you can deduct the interest for federal income tax purposes.


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